Investing

What Is a Profit-Sharing Plan?

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Updated on May 31, 2022

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Female employee seated at desk looking up at her employer — Photo:
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Definition

A profit-sharing plan is a type of defined contribution plan that allows companies to help their employees save for retirement. Employers use these plans to give their workers a stake in the company's success. It's also a nice benefit that can be used to attract new hires.

Key Takeaways

A profit-sharing plan is similar to a 401(k) plan but more flexible for the employer.
A business does not have to make contributions to the plan in years that it’s not profitable.
Employees do not have to make their own contributions to profit-sharing plans. Businesses with these plans are sharing any profits they've earned with their workers.
Workers can take profits in the form of cash or company stock.

Definition and Example of Profit-Sharing Plans

Profit-sharing plans are a way for a company to share profits with its workers. Contributions are discretionary. The company can decide how much it will put into the plan from year to year. It can even decide not to contribute at all. This flexibility makes it a nice option for both small and larger businesses. A profit-sharing plan aligns the financial well-being of workers with the company's success.

A company doesn't have to make contributions to a profit-sharing plan if it doesn't make a profit, but it doesn't have to be profitable in order to provide workers with this type of plan. Unlike 401(k) plan participants, workers with profit-sharing plans don't make their own contributions. A company can offer other types of retirement plans, such as a 401(k), along with a profit-sharing plan.

A company can legally exclude certain employees from the plan, including nonresident aliens, those who are younger than age 21, and those who are covered by collective bargaining agreements that don't provide for participation. Employees with a short tenure can also be excluded. It depends on the plan.

Note

Employees who are age 21 or older cannot be excluded from a profit-sharing plan because of age.

How a Profit-Sharing Plan Works

Employees can receive their shares of profits in the form of cash or company stock. Contributions are often made to a qualified tax-deferred retirement account. These accounts allow penalty-free distributions after age 59 1/2. Some plans offer both deferred benefits and cash. The cash is taxed at ordinary income rates.

Note

A combination of deferred benefits and cash acts like a retirement contribution plus a yearly bonus.

You can move assets from a profit-sharing plan into a rollover IRA if you leave your job, but you can be subject to a 10% tax penalty if you take a distribution before age 59 1/2. A worker might be able to take a loan from their plan while still employed.

Profit-Sharing Plans vs. 401(k)s

A salary-deferral feature added to a profit-sharing plan would define that plan as a 401(k). There are a few differences between the two.

Profit-Sharing Plans	401(k) Plans
A company contributes a percentage of its profits into an employee's plan.	Employees make contributions to their own plans via payroll deductions.
A company's contributions are discretionary, depending upon whether it's profitable.	Companies have the option of matching their employees' contributions, to a limit.

Profit-sharing plans and 401(k)s both help workers save and plan for retirement, but they are structured differently. One distinction is how the company contributes to the employee's savings effort: whether at a pre-set rate or based on company profits. While profit-sharing plans are funded fully by the employer, 401(k) plans are funded primarily through the employee's own earnings.

Both types of plans have rewards for businesses, as well. Happy workers tend to stay put for the long term, and plans that employers fund generously can also entice new talent into signing on.

Requirements for Profit-Sharing Plans

There's no set amount that a company must put into its profit-sharing plan each year, but there is a limit on the amount that can be made for each worker. This limit changes over time with inflation. The maximum contribution for a profit-sharing plan is the lesser of 25% of compensation or $61,000 in 2022, up from $58,000 in 2021.

There are also limits on the amount of your pay that goes into figuring out contributions. The limit is $305,000 for the 2022 tax year, up from $290,000 in 2021.

If the employer decides to make a contribution in a given year, it must follow a set formula to determine which workers get what, and how much they receive.

How Will Your Employer Determine Your Share?

Many employers use the "comp-to-comp" method of figuring out how much an employee will get. With this method, your employer would add up its total compensation spending for the year. Then, it would divide each employee's amount by the total to determine their share of the total pool.

For instance, suppose that your employer has a total compensation budget of $1,000,000. It decides to create a profit-sharing pool of $100,000. Your yearly compensation is $50,000.

The formula to figure out your share would look like this:

In other words, you would get 5% of the profit-sharing pool. Your share would be $5,000.

Other Requirements for Profit-Sharing Plans

Contributions can also vest over time, according to a set vesting schedule.

An employer must set up a system that tracks contributions, investments, and distributions. It must also file a yearly return with the government. These plans can require a good deal of administrative upkeep.

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Sources

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